We noted earlier this week that the U.S. has partially or fully defaulted on its debt on numerousoccasions.

We also noted that our largest creditor – China – accused the U.S. of defaulting on its debts in 2011 by weakening the dollar.

Felix Salmon argues at Reuters that the U.S. has already defaulted again … even if a debt ceiling deal is worked out before October 17th:

The situation is less binary than it looks, not least because the US government isalready in default on its obligations.

The best way to look at this, I think, is that there’s a spectrum of default severities. At one end, you have the outright repudiation of sovereign debt, a la Ecuador in 2008; at the other end, you have the sequester, which involves telling a large number of government employees that the resources which were promised them will not, in fact, arrive. Both of them involve the government going back on its promises, but some promises are far more binding, and far more important, than others.

Right now, with the shutdown, we’ve already reached the point at which the government is breaking very important promises indeed: we promised to pay hundreds of thousands of government employees a certain amount on certain dates, in return for their honest work. We have broken that promise. Indeed, by Treasury’s own definition, it’s reasonable to say that we have already defaulted: surely, by any sensible conception, the salaries of government employees constitute “legal obligations of the US“.

The markets’ faith in the U.S. is long-standing …. this comes from a deep confidence that the U.S. political system will make sound decisions — a confidence, at this point, that few of the system’s participants share and one that’s hard to square with the evidence of the past few years. The simple fact is that Congress is getting worse at avoiding the traps it sets for itself.

***

Debt ceiling increases are becoming more tenuous. The 2011 agreement lifted the ceiling until 2013. The first 2013 agreement suspended the ceiling for only three months. It’s likely that the next agreement will only hold for a matter of weeks.

Capitol Hill staffs freely admit that they don’t know how the debt limit will be routinely raised going forwards. Dispensing with his predecessor’s practice of radiating confidence amid chaos, Treasury Secretary Jack Lew has said that he’s “nervous” and “anxious” that the U.S. will breach the debt ceiling. President Obama was more blunt: “I think this time is different,” he told CNBC, adding that markets “should be concerned.”

***

Is the American political system the latest bubble? Is the markets’ faith inflated by bad historical analogies and a willful disregard of current facts?

***

Standard & Poor’s downgraded the U.S. in 2011 on the grounds that “the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.”

***

A scary possibility is that the market price on the U.S. political system doesn’t reflect what market participants are coming to believe about it: that a once capable and reliable system is now dysfunctional and unpredictable. That raises the possibility that a pivotal event could move markets dramatically because traders are prepared to believe, and to begin trading on, a much more pessimistic assessment of America’s political system. If everyone were moved to act on that belief simultaneously — by a debt-ceiling crisis, for example — the results could be earthshaking.

Gary Gorton, an economist who specializes in financial crises, put it crisply: “Financial markets can be wrong and they can be wrong in a big way because they don’t understand the situation and it only becomes clear ex-post.”

Congressional records show that the two most recent Congresses produced less legislation than any since Congress began keeping records in the 1940s.

Given such telltales, a prominent display of political dysfunction can’t easily be dismissed as a one-off. Instead, it could be the trigger that leads global markets to construct a whole new narrative about the U.S.– one that prices in the likelihood that an increasingly polarized, gridlocked Washington won’t always get it right and may increasingly get things wrong.

Postscript: Of course, most in the financial world are more focused on bonds than government employees. In other words, bonds are the only important indicator of default for most financial analysts.

But this isn’t an all-or-nothing test either. Large investors like Fidelity, Blackrock and JP Morgan, have already sold off all of their short-term treasuries. And the credit default swap market puts the U.S. at ahigher risk of default today than in 2011.

As such, the U.S. has already destroyed enough trust to have caused the market to treat this like a de facto default.

Of course, investors might pour back into the U.S. in the short run if Europe totally implodes (best-looking horse in the glue factory.)